Investors Grow Wary of ETF Securities Lending Practices

The ETF industry has long engaged in securities lending as a way to generate extra cash, but some investors have grown wary of the practice, arguing that the risks don’t justify benefits.

Securities lending is a practice where mutual funds and ETFs pay agents to lend out shares in their portfolios – the funds are created with exposure to an underlying basket of securities – to other traders and thereby earn interest.

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ETF providers would typically lend securities to investors who want to short a stock. The investors would have to borrow shares from the provider and sell them on the market, hoping that when it comes time to give the shares back, they would be able to repurchase shares at a lower price in the market and pocket the spread.

For the ETF provider, securities lending can generate extra returns, which issuers argue can help reduce management fees and even enhance an ETF’s overall performance.

However, some ETF investors are concerned that the process of loaning out these underlying securities also comes with undue risks, especially during volatile conditions or market downturns, the Financial Times reports.

“It does add an extra level of complexity to otherwise plain vanilla trackers or ETFs and could add to the risks in periods of market shocks,” Ben Seager-Scott, chief investment strategist at the Tilney Group, told the Financial Times.

Specifically, some observers are concerned about the quality of collateral an ETF accepts when it lends out its underlying securities to an outside investor. A holder would temporarily transfer a security to another investor in exchange for collateral, such as cash or other securities above the shares’ value. If the ETF needs to sell stock, it can take it out of the borrower. If the borrower is unable to deliver the shares, the ETF uses the collateral. However, some worry this would not be enough in more volatile conditions.

“I see a number of physical ETFs that often have the majority of their securities out on loan with seriously mismatched collateral – for example, holding equity collateral against government bonds on loan,” Seager-Scott said. “Day to day, this tends not to have an impact – but it could well do if we had another market crisis.”

Furthermore, cash is often used as the collateral of choice, with the ETF provider investing the cash to try and generate even higher returns than just sitting on it and receiving a fee, which adds a level of risk as well.

“You have to invest the cash to get a return and even the lowest risk investment can lead to losses,” Peter Sleep, a fund manager at Seven Investment Management, told FT. “In 2008 many US investors took cash and put that cash into what appeared to be low-risk bond funds and incurred quite large losses in the financial crisis, whereas European investors sailed serenely on.”

According to Morningstar data, about 30% of ETFs based in Europe lend out securities and almost 71% of US-listed ETFs execute stock lending.